Top 10 Financial Ratios

Summary

This video covers the top ten financial ratios tested on finance and accounting exams. It explains how each ratio is calculated, what it measures, and how to interpret the ratio. Key ratios covered include days sales outstanding, return on assets, return on equity, inventory turnover, debt-to-equity ratio, times interest earned ratio, gross margin, earnings per share, price-to-earnings ratio, and current ratio. Together these ratios assess company liquidity, leverage, efficiency, and profitability from the perspective of management, investors, and creditors.

Takeaways

• 😀 Days Sales Outstanding measures how quickly a company collects payment from customers. Lower ratio means better liquidity.
• 😎 Return on Assets ratio evaluates how efficiently a company uses its assets to generate profits. Higher ratio is better.
• 💰 Return on Equity ratio gauges profits generated from shareholders' investments. Higher ratio signals effective use of capital.
• 📈 Inventory Turnover ratio indicates how fast inventory sells. Higher turnover implies good inventory management.
• 🏦 Debt-to-Equity ratio compares debt financing to equity financing. Higher leverage increases risks and reduces flexibility.
• 💸 Times Interest Earned ratio measures a company's ability to meet debt obligations. Higher ratio indicates more financial security.
• 🤑 Gross Margin ratio shows profitability after deducting production costs. Higher margin allows more flexibility in operations.
• 💲 Earnings per Share indicates net profits attributable to each outstanding share. Useful metric for evaluating investments.
• 📉 P/E ratio compares share price to earnings per share. Higher ratio signals expectations of earnings growth.
• 🚨 Current ratio evaluates short-term liquidity and the ability to pay off short-term liabilities. Higher ratio is better.

Q & A

What does the days sales outstanding ratio measure?

The days sales outstanding ratio measures the average number of days it takes customers to pay back the business for products or services. It shows how well the company collects payment from customers.

How is return on assets calculated?

Return on assets is calculated by taking the company's net income and dividing it by the average total assets. It shows how much profit is being generated from the assets invested in the business.

What does a high inventory turnover ratio indicate?

A high inventory turnover ratio indicates that a company's inventory is being sold quickly and converted into cash efficiently. It shows effective inventory management.

What does the debt to equity ratio assess?

The debt to equity ratio assesses the degree of financial leverage being used by a company. It shows how much debt is being used to finance operations compared to the amount of shareholder equity invested.

Why is gross margin ratio important?

The gross margin ratio shows how profitable a company's sales are after accounting for the direct costs associated with production. It assesses how much flexibility a company has to cover operating expenses.

What does earnings per share indicate?

Earnings per share shows how much net income is earned per outstanding common share stock. It helps investors evaluate profitability on a per share basis.

How can you interpret a company's P/E ratio?

A high P/E ratio generally indicates investors have strong growth expectations for future earnings. A low P/E suggests poor prospects or slower growth.

What does the current ratio measure?

The current ratio measures a company's ability to pay off short-term liabilities with its current assets. It evaluates liquidity and the ability to manage debt.

What is a good current ratio number?

A current ratio of 1.5-3 is considered good. Less than 1 indicates potential trouble meeting obligations, while higher can mean inefficiency.

What are limitations of financial ratios?

Limitations include variations in accounting methods between companies, use of estimates, and not showing qualitative factors influencing performance.